© Prentice Hall, Corporate Financial Management 3e Emery Finnerty Stowe Business Investment Rules

The Capital Budgeting Process The process can be broken down into five steps as a project moves from idea to reality: 1. Generating ideas for capital budgeting projects. 2. Reviewing existing projects and facilities. 3. Preparing proposals. 4. Evaluating proposed projects and creating the capital budget. 5. Preparing appropriation requests.

Generating ideas for capital budgeting projects Research and Development Division Management Plant Management Production Management Strategic Planning ideas

Classifying Capital Budgeting Projects Maintenance Projects Cost Savings / Revenue Enhancement Capacity Expansions in Current Business New Products and New Businesses Projects Required by Government Regulation or Firm Policy

Preparing Proposals Generally, the originator presents a written proposal. Most large firms use standard forms, and these are typically supplemented by written memoranda. There may be consulting studies prepared by outside experts.

Capital Budgeting and the Required Return The required return is the minimum rate of return that you need to earn to be willing to make an investment. It is the rate of return that compensates you for the risk of the expected future cash flows. It depends on the use of the money not the source.

Net Present Value Recall that an asset’s net present value (NPV) is the difference between what it is worth and what it costs. The major difficulty of finding a project’s NPV rests with the need to see situations differently from other people in the market.

NPV example Suppose you notice a run-down house for sale in your neighborhood. The price is $80,000 as the house stands today. The house requires $40,000 worth of repairs. The repairs would take a year to complete. Fixed up, you could sell the house in one year for $135,000. Having a slightly better neighborhood increases the value of your own home by $5,000.

NPV example If your discount rate is 10%, the net present value of the project to you is $7,273: The net present value of the project to someone who does not live in the neighborhood is $2,727:

Internal Rate of Return The internal rate of return is the discount rate that sets NPV of the expected cash flows to zero. The internal rate of return is the project’s expected return. Undertake a project if the IRR exceeds r, the project’s cost of capital.

IRR example CALCULATOR SOLUTION Data Input Function Key N I PV PMT FV 6 10,000 –2, A project costs $10,000 and is expected to generate cash flows of $2,100 each year for six years. What is the project’s IRR?

Using the NPV and IRR Criteria Most of the time NPV and IRR are both valuable guides to making decisions. There are occasions, however, where NPV and IRR disagree. When in doubt, you can trust the NPV.

NPV Profile An NPV profile plots the project’s NPV as a function of the discount rate. It shows both the NPV and the IRR of the project. It can be used to identify the range of cost of capital at which the project would add value to the firm.

NPV Profile: Example Cash Flow Initial Investment Cash Flow in years 1 to 5 Cash Flow in years 6 to 9 Cash Flow in year 10 -$3,985,000 $806,000 $926,000 $1,151,000 Consider a 10-year project with these cash flows:

NPV Profile NPV ($ thousands) Discount Rate IRR 16.95% The project has a positive NPV at discount rates less than 16.95% And a negative NPV at discount rates more than 16.95%

When IRR and NPV Can Disagree Mutually exclusive Capital Budgeting Projects

Types of Projects Two projects are independent if undertaking one does not preclude the other. IRR and NPV methods agree for conventional, independent projects. Two projects are mutually exclusive if undertaking one implies rejecting the other. IRR and NPV methods can yield conflicting decisions when choosing between mutually exclusive projects.

When IRR and NPV Can Disagree Consider a firm that needs to buy a new heating system. They only need one. The choice is down to two systems: 1. System A has high up-front costs and low maintenance costs. 2. System B is inexpensive to install, but has high maintenance costs. Either system will offer savings over the current system.

When IRR and NPV Can Disagree The current system costs $400 per year to operate. The current system can be sold for $400 at time 0. The costs to install and operate the two alternative systems are shown below B ,000A

When IRR and NPV Can Disagree Project A has a much higher NPV Project B has a higher IRR IRRNPV A %$573 B %$182

When IRR and NPV can Disagree The incremental costs (after taking into account that the current system costs $400 per year to run) to install and operate the two alternative systems are shown below. The table also shows the IRRs and the NPV calculated at a discount rate of 15% IRRNPV A %$573 B %$182

rate -over Cross 45% If the discount rate is less than 45%, project A is the best choice. If the discount rate is more than 45%, project B is the best choice. If the discount rate is more than 68% don’t take A or B

Types of Projects A conventional project is one which has an initial cash flow, followed by one more more expected future cash inflows. Purchase of stocks or bonds. A non-conventional project may have several cash outflows and inflows. Some of the cash outflows may occur in the future. Projects that require major overhaul during their life.

Non-Conventional Projects Consider a proposal to mine asbestos in an ecologically sensitive area. The project will require investment of $5,200,000 today, generate 12.3 million cash inflow at the end of year one and require shut down and reclamation expenses of $7.25 million at the end of year 2. Year012 Cash Flow($5,200,000)$12,300,000($7,250,000)

Non-Conventional Projects At a discount rate of 12%, the project has a zero NPV. Does that mean that if our cost of capital is 10% that we should start the project?

NPV Profile of Non- Conventional Projects Discount Rate NPV IRR 2 = 25% IRR 1 = 12% Here we see that the project actually has two IRRs: 12% and 25% You have to be careful interpreting IRR.

Projects of Different Size Perma-Filter is considering two mutually exclusive one-year projects, whose cash flows are shown below. The cost of capital for either project is 12%. Compute the NPV and IRR for each project and indicate which one should be undertaken. Project CF 0 1 Alpha Beta ($1,000) ($8,000) $1,200 $9,200

Projects Alpha and Beta Project 12% IRR Alpha Beta $71.43 $ % 15% Choose the project with the higher NPV.

Cash Flow Timing Differences Plot each project’s NPV profile. Find each project’s IRR. If each project has a cost of capital of 5%, which project should be selected? If each project has a cost of capital of 10%, which project should be selected? Perma-Filter is considering two mutually exclusive projects, L and H. Their cash flows are shown in the table on the next slide.

Cash Flows for Projects L and H Year Project L Project H ($12,000) $1,000 $2,000 $4,000 $8,000 ($12,000) $6,000 $4,000 $2,000 $1,000

NPV Profiles for Projects L and H Project H Project L Discount Rate NPV

IRR and NPV for Projects L and H

IRR on Balance IRR is widely used in practice. More widely used than NPV actually. Many people prefer the intuitive feel of the IRR rule.

Other Widely Used Capital Budgeting Criteria Profitability Index MIRR Payback Discounted Payback

Profitability Index PI PVofFutureCashFlows InitialInvestment NPV InitialInvestment = = + 1 Decision Rule: Undertake the project if PI > 1.0

Profitability Index Perma-Filter is considering two mutually exclusive one-year projects, whose cash flows are shown below. The cost of capital for either project is 12%. Compute the NPV and the PI for each project and indicate which one should be undertaken. ProjectCF 0 1 Alpha Beta ($1,000) ($8,000) $1,200 $9,200

Profitability Index Project AlphaProject Beta Year 0 Cash Flow Year 1 Cash Flow ($1,000) $1,200 ($8,000) $9,200 12% PI $ $

Profitability Index PI measures the NPV per dollar invested. For independent projects, the PI method yields conclusions identical to the NPV method. For mutually exclusive projects, differences in project size can lead to conflicting conclusions. Use the NPV method. PI is useful when there is capital rationing.

MIRR Time Cash flows Cost of Capital = 12% PV(cash outflows) = $-1,000 FV(cash inflows) = $2, MIRR = 22.88%

Payback Method The payback is the length of time it takes for the project’s cash flows to equal its investment. Decision Rule: Undertake the project if the payback is less than a preset amount of time.

Discounted Payback Method The discounted payback is the length of time it takes for the project’s discounted cash flows to equal its investment. Decision Rule: Undertake the project if the discounted payback is less than a preset amount of time.

Payback and Discounted Payback The cash flows for two mutually exclusive projects X and Y are shown on the next slide. The cost of capital for each project is 12%. Compute the NPV, the payback, and the discounted payback for each project. Which project should the firm choose?

Payback and Discounted Payback YearProject XProject Y ($8,000) $4,000 $2,000 ($8,000) $2,000 $4,000 $6,000

Payback and Discounted Payback for Project X Discounted Year Cash Flow Cumulative Cash Flow Cash Flow Cumulative Cash Flow ($8,000) $4,000 $2,000 ($8,000) ($4,000) $0 ($8,000) $3,571 $3,189 $1,424 $1,271 ($8,000) ($4,429) ($1,240) $184

Payback and Discounted Payback for Projects X and Y Project XProject Y Payback DiscountedPayback* NPV* 2years 2.87years $1,455 3years 3.46years $2,040 * Discount rate = 12%

Payback and Discounted Payback Payback ignores the time value of money. Both require an arbitrary cutoff value. Payback ignores risk differences between projects. Both ignore cash flows after the payback period.

Urgency This method says “invest in the project when you absolutely have to.” Replacement decisions: replace asset after it has broken down! It ignores planning ahead. “A pound of prevention is worth a pound of cure!”

Capital Budgeting in Practice Most firms used more than one method for capital budgeting project evaluation. The NPV profile is the most useful item. It provides the most complete view of the project. A process for appropriating capital after the projects have been selected must be created by the firm. Review of project performance must be done periodically.

Summary The capital budgeting process and the investment criteria used to make capital budgeting decision are critical because firms are effectively defined by the products and services they provide using their capital assets.